Maybe just as important as exploring your options is offering a few cautionary words from our experience on what does not work. Most of t these lessons were learned by watching our clients do it the wrong way and listening to their stories about the consequences. There are no monopolies on good ideas, and new strategies in succession will always be evolving—
and we hope to be leading the charge—but some old methods defi nitely need to be discarded. Here is what doesn’t work (which tends to focus on compensation-based strategies as opposed to equity-based strategies), a list that, by virtue of previous discussion, must include the use of revenue- sharing arrangements.
Granting of Ownership
Rule No. 1: Do not give away your business. Don’t create a new owner in your business by presenting someone a gift of stock; it isn’t a birthday pres- ent, and the IRS stands in the background nodding its head in agreement.
Rule No. 2: If you’re going to ignore Rule No. 1, then sell stock fi rst and most, and grant stock second and least. As you read on and learn more about stock grants in the following chapter under “The Nuts and Bolts of a Plan,” you’ll come to appreciate those terms of art and understand how they will help you and your succession team assemble a state-of-the-art suc- cession plan.
That said, it is not unusual for owners of independent fi nancial services businesses to seek to reward key staff members with a grant of stock or ownership interests. Granting seems so simple, quick, and paperless. How hard can it be to give some shares of stock in an intangible, professional services business to a deserving employee, son, or daughter? It often creates (or cements) a special bond between owner and employee, soon to be
partner; obviously that holds true between parent and son or daughter.
What’s the big deal?
In short, the answer is “taxes.” This part of the game is rigged against you and you can learn more as you keep reading, but there is a possible way through this minefi eld, a way to strategically employ stock grants in a tax- effi cient and business-strengthening manner.
To that end, most stock grants involve gradually or incrementally issu- ing the shares (or units in an LLC) over time, based on a promise that ties the reward to tenure or some other measurable achievement. Instead of or in addition to a cash bonus, consider a stock bonus. This approach has the ben- efi t of the recipient being able to rely on the growing profi t distributions from previously purchased shares to help the minority owner address the tax costs associated with the grant (otherwise, a cash bonus will be needed). Finally, discounts for lack of control (for minority ownership interests) and lack of marketability (for ownership interests in privately held companies) applied to the cash value of the shares can also be used to minimize the tax burden.
In sum, the granting or awarding of stock to one or more key employees can be an important part of a comprehensive succession plan and an owner’s level compensation strategy when used properly. But it needs to be part of a plan, and not the plan itself.
Phantom Stock Plans
A phantom stock plan (PSP) is not a succession strategy. It is not even an exit strategy. It is a compensation tool.
Phantom stock plans are a useful and valuable planning tool in the right context. A PSP is actually a compensation strategy in which a business promises to pay cash at some future date in an amount equal to the market value of a number of shares of its stock. Thus, the payout will increase if the stock price (based on the value of the independent fi nancial services or advisory business) rises, and will decrease if the value of the stock falls, but without the PSP participant actually receiving any real stock. Conversely, the PSP participant has no indebtedness or similar obligation as is the case with an advisor who actually invests money into an ownership position or who signs a promissory note.
Just to be clear, rather than getting physical stock, the employee or PSP participant receives pretend stock. Even though it’s not real, the phantom stock follows the price movement of the business’s actual stock, which can be determined through an annual valuation of the business, for example.
The valuation results are shared with all PSP participants.
Like other forms of stock-based compensation plans (see Figure 6.1 ), phantom stock broadly serves to encourage employee retention, and to
align the interests of participants and actual shareholders or owners. PSP participants are typically employees, but may also be directors, third-party vendors, or others. Phantom stock is essentially a cash bonus plan, although some plans pay out the benefi ts in the form of actual shares. Every PSP is unique and can be custom drafted to fi t the circumstances and goals of the business owners and PSP participants. If you are Financial Industry Regu- latory Authority (FINRA) regulated and you want to have a nonlicensed, nonproducing key employee participate in the benefi ts of ownership, PSPs are often a great solution.
For accounting purposes, phantom stock is treated in the same way as deferred cash compensation. As the amount of the liability changes each year, an entry is made for the amount accrued. A decline in value would reduce the liability. (This is yet another reason why our more sophisticated clients, those building enduring and transferable businesses, have annual valuations performed.) These entries are not contingent on vesting. Phantom stock payouts are taxable to the employee as ordinary income and deductible to the company. However, they are also subject to complex rules governing deferred compensation that, if not properly followed, can lead to tax penalties.
Many of our clients’ attorneys recommend PSPs as a way to retain next- generation talent, to pay above-average compensation for above-average performance, and to help everyone think like an owner without actually having any real partners. If you’ve ever had a bad partner, you have to appreciate this advice. But let’s circle back to the goal of a succession plan: It is to build an enduring business, one capable of outliving you and prosper- ing even as you retire on the job, and to do that, you need real partners, not pretend partners. PSPs have their place, but if you want to end your career as a single owner, then your practice will end with you; pretend ownership makes for a pretend succession plan.
FIGURE 6.1 Compensation-Based Strategies COMPENSATION-BASED STRATEGIES
• STOCK APPRECIATION RIGHTS
• PHANTOM STOCK
• STOCK OPTION PLANS
• PROFIT-SHARING PLAN
• PROFITS INTEREST (LLCs)
• DEFERRED COMPENSATION PLAN
• DEFINED BENEFITS PLAN